My most recent books are the Leader's Guide to Radical Management (2010), The Leader's Guide to Storytelling (2nd ed, 2011) and The Secret Language of Leadership (2007). I consult with organizations around the world on leadership, innovation, management and business narrative. At the World Bank, I held many management positions, including director of knowledge management (1996-2000). I am currently a director of the Scrum Alliance, an Amazon Affiliate and a fellow of the Lean Software Society. You can follow me on Twitter at @stevedenning. My website is at www.stevedenning.com.

Is The Tyranny Of Shareholder Value Finally Ending?

“Down With Shareholder Value” Joe Nocera declared stridently in the New York Times earlier this month. “It feels as if,” Nocera wrote, “we are at the dawn of a new movement — one aimed at overturning the hegemony of shareholder value.”

Is a new era in capitalism finally dawning? The pervasive reign of shareholder value in American business won’t end unless it can be replaced with something that is actually better. There’s the rub. Nocera’s article, in discussing what might follow shareholder value, points to two fundamentally different schools of thought. One school harks back to failed ideas of the past (managerial capitalism) while the other points directly to a fresh and more promising future (customer capitalism).

To understand what’s going on, we need to dig into a little history and figure out how and why the strange notion of shareholder value—the dumbest idea in the world, according to Jack Welch—ever got going in the first place.

Managerial capitalism: balancing many goals

The predecessor to shareholder value, says Roger Martin, the dean of the Rotman School of Management at the University of Toronto, was “managerial capitalism”. This idea emerged in 1932 with the publication of the legendary book: The Modern Corporation and Private Property by Adolf A. Berle and Gardiner C. Means.

The book put forward the then-radical notion that firms ought to have professional management. According to the book, ideally managers should be a “purely neutral technocracy balancing a variety of claims by the various groups in the community and assigning to each a portion of the income stream on the basis of public policy rather than private cupidity.” The book became the “economic Bible of the Roosevelt administration.”

Also in 1932, Professor Merrick Dodd wrote in Harvard Business Review that ‘the proper purpose of a public company went beyond making money for shareholders and included providing secure jobs for employees, quality products for consumers, and contributions to the broader society.” This thinking prevailed for the next forty years or so.

Garbage can organizations

The problem with managerial capitalism is that organizations balancing multiple goals tended over time to become confused and ineffective.

In 1972, a trio of academics–Cohen, March and Olsen—explained that pursuing multiple goals caused organizations to resemble “garbage cans” with three main characteristics. First “the organization operates on the basis of a variety of inconsistent and ill-defined preferences.” Second, the organization’s “own processes are not understood by its members.” Third, “the audiences and decision makers for any particular kind of decision change capriciously.”

As a result, “choices are made only when the shifting combinations of problems, solutions, and decision makers happen to make action possible.” The process “does not resolve problems well.” “Poorly understood problems that wander in and out of the system”, as “decision-makers have other things on their mind.”

The epitome of the “garbage can” organization was the mid-20th Century university—the environment where the trio of academics developed their ideas. But the garbage can theory of “organized anarchy” had wider applicability. It enjoyed considerable popularity from the fact that it could “describe a portion of almost any organization”.

The answer: a single goal: shareholder value

By the 1970s, as global competition started to make inroads into American business, the “organized anarchy” of garbage can organizations was increasingly perceived as problematic. Big firms were seen as too complacent and unresponsive to competitive pressures.

In 1970, Nobel-prize winning economist Milton Friedman led the charge with an article in the New York Times that argued forcefully that because shareholders owned the corporation, the only social responsibility of business was to increase its profits.

By 1973, Peter Drucker was writing in his classic book, Management, that both “the typical businessman” and “the typical economist” believed (falsely in Drucker’s view) that the purpose of a firm was to make a profit.

In 1976, in a strange, unread but frequently cited article, a pair of academics–Meckling and Jensen—combined nonsensical psychology with abstruse mathematics to offer an academic cover for going all-in for shareholder value and lavish executives with stock that would encourage them to focus single-mindedly on this goal.

“Since it is logically impossible to maximize in more than one dimension,” Jensen argued later, “purposeful behavior requires a single valued objective function.” If there had to be just one objective of the corporation, maximizing shareholder value was the obvious choice.

In the 1980s and 1990s, Jack Welch CEO at GE from 1981 to 2001 and Roberto Goizueta, CEO of Coca-Cola from 1981 to 1997 became the models. Both firms did very well for their shareholders during their tenure as well as for themselves. Goizueta became the first American manager to become a billionaire on the basis of stockholdings in a company that he had neither founded nor taken public.

Maximizing shareholder value: the dumbest idea in the world

Maximizing shareholder value is a powerful idea. It is simple. It is elegant. It is intuitive. It has at least one big problem: it doesn’t work.

As Roger Martin wrote in 2010: “Have shareholders actually been better off since they displaced managers as the center of the business universe? The simple answer is no.” It became steadily more apparent that focusing attention solely on shareholder value in the short term tended to lead to the management to do things that destroyed long-term shareholder value. The stagnation of Coca-Cola after Goizueta’s departure and the precipitous decline of GE’s market cap since Jack Welch’s departure have been startling.

Lorsch and Fox write in HBR: “There’s a growing body of evidence (for example, Rosabeth Moss Kanter’s “How Great Companies Think Differently,” HBR November 2011) that the companies that are most successful at maximizing shareholder value over time are those that aim toward goals other than maximizing shareholder value.”

And even Jack Welch himself had second thoughts. In 2009, he gave an interview with the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.”

Shareholder value morphs into C-suite capitalism

Even worse, shareholder capitalism morphed into something else: C-suite capitalism. “Maximizing shareholder value” turned out to be the disease of which it purported to be the cure. Roger Martin writes that between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990, CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.

Since 2000, the situation has only deteriorated. According to Professor Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School, over-compensation of the C-suite has produced a giant financial incentives bubble, that is inexorably pushing the US economy into decline. His 2012 HBR article makes clear that overcompensation of the C-suite is not merely an issue of “fairness” or “whining by the 99 percent”. The phenomenon is having disastrous business consequences, including a serious misallocation of capital and talent, repeated governance crises, rising income inequality and an overall decline of the US economy.

At the heart of the disaster, according to Desai, is market-based compensation—the idea that the C-Suite and financial managers should be compensated by the issuance of stock. The idea was intended to align managers’ interests with those of shareholders, but the result has been the opposite. According to Desai, the idea of market-based compensation is “intellectually flawed” and “a foundational myth.”

Even more disastrously, the skewed incentives and huge unearned windfalls have given rise to righteous but unwarranted belief in entitlement: the inhabitants of the C-suite “now consider themselves entitled to such rewards. Until the financial incentives bubble is popped, we can expect misallocations of financial, real and human capital to continue.”

Where to from here?

Back to New York Times article and the dawning of a new era for capitalism: Joe Nocera cited two schools of thought in support of a new dawn:

Stakeholder capitalism: Professor Stout’s new book, The Shareholder Value Myth and the 2012 HBR article by Lorsch & Fox: What Good Are Shareholders?

Customer capitalism: Roger Martin in Fixing The Game and his 2010 HBR article, The Age of Customer Capitalism.

Let’s look at each school of thought. One leads forward into the future. The other leads back into the past.

Stakeholder capitalism

In their HBR article, Lorsch and Fox recommend stakeholder capitalism. “Giving a favored role to long-term shareholders, and in the process fostering closer, more constructive relationships between shareholders, managers, and boards, should be a priority. So should finding roles for other actors in the corporate drama–boards, customers, employees, lenders, regulators, nonprofit groups–that enable those actors to take on some of the burden of providing money, information, and especially discipline. This is stakeholder capitalism.”

And Professor Stout makes a similar proposal. She suggests looking at an array of alternatives that

“share a common theme: they all sever the supposed linkage between ‘shareholder value’ and shareholder welfare by showing how different shareholders have different interests and values. They also all suggest how giving managers discretion to balance among different shareholders’ competing interests can ultimately serve the interests of investors as a class, over time, better than a strict shareholder primacy rule would….

“To build enduring value, managers must focus on the long term as well as tomorrow’s stock quotes, and must sometimes make credible if informal commitments to customers, suppliers, employees, and other stakeholders whose specific investments contribute to the firm’s success.”

The risk of a return to garbage can organizations

With its balancing of the interests of multiple stakeholders, stakeholder capitalism is hard to distinguish from managerial capitalism of the mid 20th Century. Balancing multiple interests may work in the context of a board of directors that has the time and expertise to spend days or weeks, say, on evaluating a single multi-billion decision on an acquisition.

But as a guiding principle for driving growth and innovation throughout a large organization, it’s impractical. It risks taking us back to the world of garbage can organizations, characterized by “a variety of inconsistent and ill-defined preferences,” with “processes not understood by its members,” while “audiences and decision makers for any particular decision change capriciously.”

In a large organization, managers and staff are making decisions every day. For the organization to have a clear direction, the leadership must be clear and simple if their guidance is to be understood and implemented.

For instance, Jim Sinegal at Costco uses stories to show how Costco resolves the conflict between two competing values: serving the customer and making a profit. One story, as told to Evelyn Clark in Around the Corporate Campfire, is as follows:

We were selling Calvin Klein jeans for $29.99, and we were selling every pair we could get our hands on. One competitor matched our price, but they had only four or five pairs in each store, and we had 500 or 600 pairs on the shelf. We all of a sudden got our hands on several million pairs of Calvin Klein jeans and we bought them at a very good price. It meant that, within the constraints of our markup, which is limited to 14 percent on any item, we had to sell them for $22.99. That was $7 lower than we had been selling every single pair for.

Of course, we concluded that we could have sold all of them (about four million pairs) for that higher price almost as quickly as we sold them at $22.99, but there was no question that we would mark them at $22.99 because that’s our philosophy.

I use that as an example because it would be so tempting for a buyer to go with the higher price for a very quick $28 million in additional profits, but ours didn’t. That’s an example of how we keep faith with the customer.

If Sinegal were instead to invite managers and buyers to use their own judgment on each decision to “balance the needs of all the different stakeholders,” it is hardly likely that staff would consistently make the right decision for the customer or that Costco would be as successful as it is. As Sinegal says, the temptation would be too great. Stakeholder capitalism, like its predecessor managerial capitalism, lacks the clarity to be an effective guiding star of managerial behavior throughout a large organization.

The problem compounded: C-suite capitalism

What’s new today? The additional complication is that now the C-suite is being hugely compensated to favor a focus on the stock price. In such a situation, it’s not hard to figure whose interests are going to dominate the decision-making. The C-suite will be calling the shots.

Within the organization, if middle managers are asked to make each decision while balancing multiple interests, there might be endless debates about goals. More realistically, the old realities of making the quarterly numbers and feeding the bottom line with profits will still prevail.

What didn’t work in the mid 20th Century is even less likely to work in the more competitive world of today.

The real issue for today: corporate survival

When the advocates of managerial and stakeholder capitalism talk about their theories, they sound curiously remote from the harshly competitive world of the 21st Century marketplace. The problem they seem to be addressing is: how do we distribute a given stream of benefits among various stakeholders?

In 2012, the more relevant managerial issue is: how to assure that there will be any stream of benefits to distribute? With the life expectancy of firms in the Fortune now down to less than 15 years and declining fast, the issue has become urgent.

The only valid purpose of a firm

As it happens, Peter Drucker gave us a clue, way back in 1973. He addressed the question: why do we have organizations in the first place? and wrote:

To know what a business is, we have to start with its purpose. Its purpose mut be outside of the business itself. In fact, it must lie in society since business enterprise is an organ of society. There is only one value definition of business purpose: to create customer…

It is the customer who determines what a business is. It is the customer alone whose willingness to pay for a good or for a service converts economic resources into wealth… What the business thinks it produces is not of the first importance—especially not to the future of the business and its success…. What the customer thinks he is buying, what he considers value, is decisive—it determines what a business, is, what it produces and whether it will prosper. And what the customer buys and considers value is never a product. It is always utility, that is, what a product or service does for him…. The customer is the foundation of a business and keeps it in existence. He alone gives employment. To supply the wants and needs of a customer society entrusts wealth producing resources to the business enterprise.

Customer capitalism

Peter Drucker was a man of his times and did not foresee the eventual implications of his insight. In 1973, global competition was just getting under way and the shift in power in the marketplace from seller to buyer as a result of the Internet had yet to happen. In 1973, the world had not yet seen the exponential growth that would occur when firms like Apple [AAPL] or Amazon [AMZN] or Salesforce [CRM] or Costco [COST] fully dedicated themselves to delighting customers. The world had not yet seen the full development of Agile management as an alternative to hierarchical bureaucracy that could combine disciplined execution with continuous innovation. Nor had the world yet discovered how to measure in a simple and practical way whether and to what extent they were adding value to, and delighting, their customers.

By 2010, when all those elements were in place, the world was ready for customer capitalism. Roger Martin writes:

“We must shift the focus of companies back to the customer and away from shareholder value,” says Martin. “The shift necessitates a fundamental change in our prevailing theory of the firm… The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.”

If you take care of customers, writes Martin, shareholders will be drawn along for a very nice ride. The opposite is simply not true: if you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either. In the real market, there is opportunity to build for the long run rather than to exploit short-term opportunities, so the real market has a chance to produce sustainability. The real market produces meaning and motivation for organizations. The organization can create bonds with customers, imagine great plans, and bring them to fruition.

Similarly in Reorganize for Resilience, Ranjay Gulati writes:

Those companies built around an inside-out mind-set—those pushing out products and services to the marketplace based on a narrow viewpoint of their customers that looks at them only through the narrow lens of their products—are less resilient in turbulent times than those organized around an outside-in mind-set that starts with the marketplace, then looks to deliver creatively on market opportunities. Outside-in orientation maximizes customer value—and produces more supple organizations. Embracing an outside-in perspective—focusing on creatively delivering something of value to customers instead of obsessing over pushing your product portfolio—builds an inherent flexibility into organizations.

Customer capitalism has advantages similar to those of shareholder capitalism. It is simple. It is clear. It is elegant. It is measurable. It is implementable. What’s different is that it actually works. It is theoretically sound, inspiring for employees, and hugely profitable.

A radically different way of managing

Yet customer capitalism isn’t easy for traditional managers to implement because it requires a fundamentally different way of managing. It’s a new ecosystem, a new way of speaking, thinking and acting in the work place. It implies not just a new organizational goal, but also a number of other changes in managerial behavior:

a shift from controlling individuals to self-organizing teams;

a shift from coordinating work by hierarchical bureaucracy to dynamic linking;

a shift from a preoccupation with economic value to an embrace of values that will grow the firm; and

a shift from top-down communications to horizontal conversations.

These shifts imply a revolution in the way firms are run. Fortunately there are many books describing the change, which has yet to be absorbed by business schools, business journals and consulting firms, let alone the C-suites that are running the organizations.

Economics will drive the change

Nevertheless, despite the challenge of implementation, the transition to customer capitalism is occurring inexorably, not because academics recommend it or merely because it is better for customers, for employees and for society as a whole, but rather because it defeats shareholder capitalism on its own terms: it is more profitable for the organization itself. The economics of firm profitability will drive it forward. Because firms in the new mode are radically more profitable than traditional firms focused on shareholder value and being managed with hierarchical bureaucracy, the old firms are going out of business faster and faster. They are being replaced by new organizations that have the agility to survive in the brisk competition of today’s marketplace.

So Nocera is right that the era of shareholder value is dying and a new era is dawning. The new era is however not the path of stakeholder capitalism, which takes us straight back into the past of garbage can firms and organizational anarchy. It is the path of customer capitalism, which leads to exponential growth in profitability, delighted customers and inspired workers.

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Is there any research into benign capitalism, or family capitalism where, absent or ignoring stock market pressures, a company doesn’t try to squeeze every last cent of profits? A key example would be newspapers, which often were overstaffed, would throw extra pages into a paper when the news warranted and participated in the community for better or worse, sometimes. A former colleague recalled that the publisher in Wisconsin would see some layouts that had been on the bank a few days and order an extra four pages to get them printed. Now that Gannett runs the operation, I suspect that doesn’t happen.

It’s hard to get reliable information on private or family owned firms. I am not aware of any comprehensive research. Even firms that are well known and celebrated and written about in HBR, like the tomato processing firm Morning Star, don’t offer any financial data. So we have to take on trust that they are “doing well”. One often hears that such firms often “do well”, but how they stack up with public companies, I don’t know.

Newspapers would be a difficult sector to sort out, because the sector itself is going through such a turbulent technological and market transition. It would be very hard to figure out the dimension related to ownership as compared to other factors. My sense is that most newspapers, whether public, private or family, have been slow to accept and adapt to the new market realities.

Nice recap and always interesting reading. “Finally Ending” – No, consider yourself on hour one of day one. The best one I ever saw was canceling all the cost savings programs that cost money to implement – but it added to the bottom line for that quarter.

Thanks for your comment. I think “hour one of day one” is a little bit on the pessimistic side. :-}

I agree that there’s still a lot of change that needs to happen, and a lot of entrenched interests supporting the status quo. But the economics of change are so powerful and so obvious that when things happen, they will happen very quickly. All the elements are already in place.

Great article, Steve. The key, I think it to recognize who your customers actually are. Customer Capitalism works when you understand your customers are those who are willing to economically participate for being delighted. I have had this conversation with many of my business clients who reference their reality that part of what delights the customer is getting free stuff – that is something that is not profitable they say. My response is that they are not the right customers to delight.

Great summary of how we got to here and possible options to replace shareholder value. The challenge I see with a singular focus on the customer is that their self-interest will sometimes come in conflict with other constituents’ interests. Wal-Mart’s customers, for example, may be happy with very low prices, but those don’t come w/o a cost – product and production are sourced outside the US, for example, and employee wages are kept below subsistence level.

While focusing on just one constituent is easier than optimizing across multiple constituents, I think we’ve proven a balance must be struck.

“The challenge I see with a singular focus on the customer is that their self-interest will sometimes come in conflict with other constituents’ interests.” I am not sure that is the case. Once a firm focuses on delighting customers, it has to treat employees right, otherwise it will fail. And delighting customers makes more money for shareholders. Focusing on customers–the only valid purpose of a firm–tends to achieve the necessary balance.

“Wal-Mart’s customers, for example, may be happy with very low prices, but those don’t come w/o a cost – product and production are sourced outside the US, for example, and employee wages are kept below subsistence level.” Walmart has a broken business model based on providing cheap products when it is no longer the cheapest. It is not delighting its customers. It is in a downward spiral from which it will not survive unless it changes course. In the course of the spiral, it treats its workers badly.

“While focusing on just one constituent is easier than optimizing across multiple constituents, I think we’ve proven a balance must be struck.” I think what has been proven is that (1) the result must achieve a balance and (2) shareholder value has failed to achieve that balance and (3) telling everyone in the firm to make their own decision on what will achieve that balance doesn’t work.

Excellent blog Steve, and a nice review of recent history and the current state of play. But I think we have to go back even further to understand the development of capitalism from its roots in the entrepreneurial communities of trust and practice of 17th century England to the present day.

Only then can we develop a new compelling narrative for capitalism. I talked a bit about this in a blog of mine earlier this week:

“Milton …because shareholders owned the corporation, the only social responsibility of business was to increase its profits.”

I think the crux of the problem has more to do with the profit concept than with the shareholder-value concept. If society were to redefine what constitutes shareholder value, say in terms of shareholding the Earth, we would be far better off. (Of course, we could also try to redefine “profit”.)

Drucker: “To supply the wants and needs of a customer society entrusts wealth producing resources to the business enterprise.”

I think the key to a long-term viable economic structure is a nugget in Drucker’s quote. Ultimately, any such structure will have to incorporate the feedback cycles of Earth’s finite resources, and to establish a context that protects against enterprises violating the trust society bestows.

In particular, this new structure will need to displace the profit motive (the sole legal mandate of a corporation) with resource stewardship (not dominion). That is, the profit-based economy must be replaced by a resource-based economy.

Unfortunately, a stable transition from the current system seems impossible. Rather, as with most change, it will more likely require a severe upheaval.